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Carbon Trading

Carbon Trading. Designing the Canadian Market. Presented by Léon Bitton, VP R&D Montreal Exchange Winnipeg, March 14th, 2003. Montréal Exchange (MX). Sole Financial Derivative Exchange in Canada. Bourse Trades all $CDN Interest Rate Derivatives

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Carbon Trading

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  1. Carbon Trading Designing the Canadian Market Presented by Léon Bitton, VP R&D Montreal Exchange Winnipeg, March 14th, 2003

  2. Montréal Exchange (MX) Sole Financial Derivative Exchange in Canada • Bourse Trades all $CDN Interest Rate Derivatives • Bourse Trades all Canadian Equity Derivatives

  3. Dimension of The Montreal Exchange Market $ Traded / Notional value 2002 Interest Rate Derivatives : 5 $ trillion Equity Derivatives : 143 $ billion

  4. +15% +24% +20% 60 000 +9% 50 000 Daily average Variation 2002 vs 2001 40 000 30 000 20 000 10 000 2002 EquityIndexFutures Equity options Total Interest-rate futures 2001 02 / 01 *Open Interest: +31% MX VolumesGrowth by Asset Class 2002

  5. MX Highlights • Restructuring program MX Alberta TSE Vancouver Senior equities CDNX Derivatives CDCC 100% TSX

  6. MX Highlights • Demutualization • First North American Traditional Derivative exchange to be fully electronic • Creation of an on-line Training Institute • Remote Access USA / UK • BOX – New US option Exchange

  7. Why an electronic exchange? Direct access MONTRÉAL VANCOUVER LONDON TORONTO WINNIPEG NEW YORK CHICAGO CALGARY AuthorizedPersons BrokerDealer FCMs,ProprietaryFirms

  8. MX Electronic Trading Platform • An open electronic trading platform using the following main components: • NSC trading system used by several exchanges around the world • Open architecture allowing firms to connect using their own proprietary front end solutions or one developed by an Independent Software Vendor (ISV) • Internet based connection – Under review

  9. DataDissemination And Clearing Trading Post trading Access SAM • Independant Service Vendor (ISV) using MMTP protocol (SLE screen) • ISV using FIX protocol • ISV and Order Flow Provider (OFP) using STAMP protocol Market Data(HSVF protocol) Communication (HUB)Gateways Order & Quote Participants T S X Trading Engine (NSC) Data VendorsParticipants & ISVs(SLC Screen) Trade &Market Data Order & Quote Mind Trade Management Database Data Dissemination Surveillance Tools Trade information C D C C MarketData Montreal Exchange Internet Site Canadian Press Trade confirmation Automated Trade Reporting to Participants (ATR) Trade Market Datafor underlying Trade &Allocation information • Participants • Back Office The Trading Process

  10. A Unique Market Model • Key characteristics: • Price transparency • Fairness • Expanded access • Rapid order execution • Straight through processing for execution • Flexibility of trading hours • Enhanced liquidity • Security

  11. The Canadian DerivativesClearing Corporation (CDCC) Clearing House carries out three main functions: • Registers and manages commitments resulting from market transactions (back-office function) • Provides protection against counterparty credit risk (netting function) • Ensures the financial integrity of the market

  12. CDCC Members Client Client CDCC – A factor ofcompetitiveness • Manages a nominal risk of approximately 600 billion $ • “AA” rating from Standard & Poor’s • 33 members • Major financial institutions • Contribution to Clearing fund and margin: 1,9 billion $

  13. Price fixing Instruments Futures Forwards Swaps Price Limiting Instruments Options Derivative Instruments Two kinds of hedging instruments Two distinct markets for execution Exchange based Off Exchange – bilateral OTC

  14. Total Worldwide Exchange Derivatives volume by Asset Class* * Source: IOMA 2001

  15. Dimension of Derivatives Market Global notional outstanding in OTC derivatives markets * Source : BIS

  16. Dimensions of Derivatives Market The Global Cash and Derivative Market/Equity

  17. Significance of Being Exchange Traded • Standardization facilitates market liquidity • Futures are price transparent, ensuring fair prices • Anonymity • Clearing corporations reduce counterparty risk • Margin • S&P rating

  18. Comparison of Markets

  19. Prerequisite for an efficient Market – Diversity of users and concentration of liquidity • Hedger is managing risk, either through a price fixing process (futures) or by taking out insurance (options). • Speculator is taking risk - using investment decision as primary source of income • Arbitrageur is special - exploiting variations in market conditions • credit, tax treatments, liquidity

  20. 0 5,000 10,000 15,000 20,000 emission allowances An illustration of emission allowances and futures trading • At the beginning of 2003, a coal-fired power plant receives allowances matching its carbon dioxide (CO2) emissions cap, say 20,000 emission allowances (hypothesis: 1 emission allowance equals 1 ton of CO2 emissions):

  21. Surplus 0 5,000 10,000 15,000 20,000 emission allowances First situation: surplus of emission allowances ‣ ‣ ‣ Selling futures. • In December, the CO2 emissions of the plant equal only 15,000 tons thanks to the implementation of new CO2 filters: • Alternative 1:If the treasurer of the plant knows that the implementation of new CO2 filters will lower its C02 emissions below 20,000 and if he plans to sell the surplus, selling a Dec 03 futures contract on 5,000 allowances @12 will place a floor to the December 2003 market price. • Alternative 2:The plant may keep the surplus for use against its target in future years or sell it to a trader at the market price.

  22. Shortage 0 5,000 10,000 15,000 20,000 25,000 emission allowances Second situation: shortage of emission allowances ‣ ‣ ‣ Buying futures • In December, the CO2 emissions of the plant reach 25,000 tons, it is a shortage of 5,000 allowances. • Alternative 1:If the treasurer of the plant anticipates an increase in the C02 emissions,buying a Dec 03 futures contract on 5,000 allowances @12 will cap the December 2003 price. • Alternative 2:The treasurer of the plant will buy 5,000 allowances at the market price to fill up the shortage in allowances.

  23. Benefits of the futures market • The futures market improves risk transfer by enhancing the ability of investors to hedge or assume risk. • The futures market contributes to the overall efficiency and liquidity of the cash market. • The futures market improves the transparency of the market.

  24. Using Derivatives =Good Business Practice • Flexible • Cost-Effective • Maximize Returns • Manage Risk

  25. Prerequisites for an Efficient Emissions Trading Market • Liquidity • Need: • Sizeable market volume and sufficiently high number of market players • One-stop shopping for spot and derivatives contracts • Economic efficiency/minimized infrastructure cost • Diversity of market players • Need: • Different market participants with different background and different targets (power generators/industries/traders/financial institutions) • Cross-border activity • Standardization • Need: • Standardised underlyings because they reduce market fragmentation, facilitate risk management and reduce transaction costs

  26. Prerequisites for an Efficient Emissions Trading Market (con’t) • Risk management tools / Certainty • Need: • Improved risk management through Derivatives Market. • Sound Exchange and Clearing House • Need: • A centralised market place through which buyers and sellers trade carbon emissions and futures with reduced credit risk exposure. • An Exchange with a market - Neutral position and good reputation for fairness and transparency in the conduct of trading • Trade facilitation: electronic access and transparent model. • Legal Framework • Need: • Establishment of the framework and rules governing the market.

  27. Carbon Trading Market Design

  28. The Mission of a Carbon Exchange • To provide a one stop shopping for spot and derivative contracts on Canadian environment products. • Early launch to enable Canadian business to gain practical experience of emissions trading ahead of the implementation of the Kyoto Protocol (2008-2012).

  29. Benefits of an Exchange • Trading emission allowances is no different from trading any other commodity. Anyone who holds an account in a central registry will be able to buy and sell allowances. • An electronic emission trading system will provide industry, governments and other organizations in Canada with the opportunity to buy and sell emission reductions at a reduced overall cost.

  30. Electronic Trading Platform (open architecture) TrainingInstitute Remote Access Expertise«know-how» Real time pricedissemination Clearing andSettlementService Selfregulatoryauthority Central creditCounterparty MX Value proposition: An integrated spot and derivatives cost-effective solution

  31. For more information • Bourse de Montréal • www.m-x.ca • Derivatives Institute • www.derivatives-institute.com • LéonBitton • lbitton@m-x.ca

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